Why Mutual Funds Are Averse To Segregating Stressed IL&FS Assets

There could be two reasons: it increases disclosure requirements and also impacts performance incentives of fund managers, according to multiple asset managers BloombergQuint spoke with. They didn’t want to be identified because a regulator is involved.

Crisil and India Ratings downgraded non-convertible debentures of Jharkhand Road Projects Implementation Company Ltd., a subsidiary of government-controlled IL&FS Group, to ‘default’. There’s an immediate threat of four more operating arms of the infrastructure group defaulting on obligations after Jharkhand Road Projects asked its debenture trustee to discontinue future disbursement from the escrow account that was servicing the non-convertible debentures of the issuer citing the company law appellate tribunal’s moratorium, according to India Ratings.

This is the second time IL&FS group has caused a scare in the debt market since September. Mutual funds were forced to write down their exposure to the group entities after rating agencies downgraded them to debt following a series of defaults. That also triggered a credit crunch for non-bank lenders, causing a fear of a contagion. The government took over and appointed a board led by veteran banker Uday Kotak.

Onerous Disclosure Norms, Recovery Fears

Fund houses are yet to segregate the assets—what’s called side-pocketing in industry parlance—more than a month after it was allowed by SEBI. The mechanism lets them separate distressed, illiquid and hard-to- assets from other more liquid assets in a portfolio. That prevents the distressed assets from damaging the returns generated by better-performing ones. To be sure, it’s optional.

Still, the guidelines clearly allow that if one instrument of the issuer has defaulted and future issues are on the verge of default, the fund house has the discretion to side pocket even before it defaults, Dhirendra Kumar, founder and chief executive officer of Value Research, told BloombergQuint over the phone. Mutual funds need not wait for a default to happen, he said.

But if an asset manager chooses to segregate distressed assets, the fund will have to follow stringent disclosure guidelines, including communication to current and future investors, the people quoted earlier said citing SEBI’s regulations. The offer document also requires adequate disclosure on side-pocketing of an asset, they said.

To prevent misuse of side-pocketing, SEBI puts the onus on the trustees of the asset management companies to cut the performance incentive of fund managers and chief investment officers who made the investment decision. It also allows for clawback of incentives disbursed to fund managers. That’s another reason why funds are not keen on side-pocketing, said some of the mutual fund experts BloombergQuint spoke to on the condition of anonymity.

Another senior official with a mutual fund, however, said enabling side-pocketing requires a series of actions that could take more than month to implement. For sudden unanticipated events like IL&FS special purpose vehicle default, the regulations are not helpful, the person said. To be sure, the regulations allow side-pocketing if the offer document of the scheme has provisions for segregated portfolio with adequate disclosures.

But Kumar said SEBI’s circular overides lack of enablement. The regulation allows fund houses to take action without delay, he added.

AMCs are also required to have a detailed written down policy on creation of segregated portfolio and the same shall be approved by the trustees. Fund houses are still in the process of formulating this policy one month into the new framework.

Mutual Fund Schemes Under Watch

ICRA Ltd. has put six schemes of three asset management companies— HDFC AMC, Aditya Birla Sun Life AMC and UTI AMC—under watch with negative implications driven by their exposure to these special purpose vehicles. The schemes risk downgrade of their credit score if further defaults happen. The re-balancing of their portfolio will be closely watched over the next one month, said ICRA in its note.

Asset managers have to completely mark down exposure to companies that have been downgraded to default. Until the recent rating cut, they avoided doing that for IL&FS’ special purpose vehicles arguing that these are operating assets with cash flows and debt is serviced through escrow accounts. But India Ratings had in its Jan. 15 report had forewarned about the possible impact of the NCLAT order.

A Write-Down In Hope Of Getting More In Future

A Balasubramanian, chief executive officer of Aditya Birla Sun Life AMC, which has exposure to IL&FS’ Jharkhand road asset, said the question of side-pocketing does not arise at all since the impact is marginal. The fund opted to mark down the net asset to the extent of exposure. Its scheme has 1.15 percent exposure to the Jharkhand SPV.

UTI AMC, whose three schemes have over 5 percent exposure each, said in a statement to BloombergQuint that it will seek clarification from the NCLAT at the next hearing on Jan. 28. In case the interpretation goes against the company, the lenders are contemplating a challenge and UTI AMC will take all necessary actions to safeguard the interests of its investors, it said.

HDFC AMC didn’t respond to BloombergQuint’s emailed queries.

According to Kumar, mutual funds have another reason to retain the assets. All defaults have the likelihood of recovery but the regulations are such that the valuations take a hit immediately, he said. Recovered amount is shared with investors pro-rata. “There is a residual to an asset and one may be able to recover more than what it is.”